The Case Against Mutual Funds Part 5

The Zero-Sum Game.

Investing in a stock is participating in the profits of a company. It is possible for a group of shareholders to buy stocks in a company and all win together. Ideally, there are no losers as all shareholders participate in the value creation of the company and its employees.

Correspondingly, investing in the entire stock market (by purchasing an Index Fund/ETF) is participating in the profits of an economy. Ideally, every participant in an economy gets up every weekday, goes to work and adds some value. In aggregate, net positive value is created.

For this reason, over a suitably long period of time, you can reasonable expect the value of an investment in a the entire market of a mature, dominant economy (such as the US) to increase. Any trading of shares between parties owning shares does not add any extra value to the economy. In fact, one can argue that trading costs, sales fees, management fees, etc. add friction to the transaction and serve to decrease overall value. At best, trading of shares between two parties is a zero-sum game. There’s typically a winner and a loser.

To extend the above, it’s easy to see that the entire mutual fund industry is a zero-sum game (with fees attached). If we gather every mutual fund that invests in the US stock market and combine all of the stocks that all of these funds hold into one “basket”, you would likely find that this basket consists of all of the stocks in the market, in quantities that closely resemble that of the S&P 500 index.

In an ideal world, these funds, in aggregate, would rise and fall exactly the same as the market itself. Separately, you would expect half of these funds to have beaten the market while the other half would have performed worse.

Of course, given that funds charge management fees, pay trading and sales expenses as well as taxes every time they buy and sell a share, we know that, in aggregate, these funds must perform significantly worse than the market. Separately, research has shown that over long periods of time very few mutual funds actually beat a passive market investment.

Ultimately, if you’re buying mutual funds, you’re paying your fund manager to take money away from your neighbour’s fund manager. It’s a zero-sum game that’s best avoided.

Recent Comments